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24 Sept 2018

Investor skepticism helps keep the U.S. bull market going

Near-term sentiment according to the Ned Davis Crowd Sentiment Poll—a contrarian indicator at extremes—has become modestly elevated in the optimistic zone, which could signal a near-term pullback. But actions are more important than words: according to data compiled by ISI Evercore Research, mutual fund and exchange-traded fund (ETF) fund flows continue to be out of equities and into bonds—not exactly euphoria.

This lack of exuberance among investors has helped to improve the valuation picture. According to earnings data from Thomson Reuters, the forward price/earnings (P/E) ratio for the S&P 500 has moved from close to 19 to start the year to just below 17 currently—not cheap but not much worse than reasonably valued in our view. Earnings have grown faster than stock prices have risen as investors have been hesitant to jump in with both feet. And given the risks that persist—including midterm elections, ongoing trade tensions, political and geopolitical developments and dysfunction, etc.—we don’t think investors should dive in head first. But as we believe we remain in a secular bull market, we do believe investors should remain invested in U.S. stocks at normal allocation levels; remaining diversified and considering periodic rebalancing back to targets. Recent leadership shifts we’ve seen in S&P 500 sectors may be sending a signal about a change in market character. Some recent leaders in the technology sector have taken it on the chin, resulting in a shift in market leadership to slightly more defensive areas—warranting some caution in the near term in our view.

Firing on all cylinders?

We have a strong but not overheating economy, which should continue to support a healthy earnings picture, but investors should temper expectations that the somewhat-blistering pace of growth in the second quarter is likely a new trend. The labor market remains strong and getting tighter by the day; with 201k non-farm payroll jobs added in August according to the Department of Labor, while the unemployment rate remained at a historically low 3.9%. The more forward-looking initial unemployment claims continue to plumb their lowest levels since the late-1960s.

What may keep economic growth from lurching higher from its second quarter pace could be a cap in resources. Stories abound from corporate executives about the difficulty in finding skilled workers and finding trucking capacity to ship goods, among other restraints on growth.

One recent bright spot has been the improvement in productivity growth; with second quarter non-farm productivity coming in at an improved 2.9% annualized rate. With capex plans increasing according to the National Federation of Independent Business (NFIB), there is the potential for productivity to improve even more.

Trade risks remain, but little broad impact to this point

For now, capex remains healthy with both Institute of Supply Management’s (ISM) Surveys—manufacturing and services—moving higher on both the headline level and the forward-looking new order component.

But within the ISM manufacturing survey, respondents did note that one of their most vexing concerns was trade. While there have been some positive signs, especially with regard to a potential NAFTA deal, the dispute with China has not improved, with new tariffs being threatened and neither side looking like they’re willing to give in to make a deal. Should trade tensions deteriorate further, capex plans would likely be formally delayed, hurting productivity and economic growth. But the flipside is also possible—deals are made and capex spending accelerates.

Fed not out to crash the party

Trade concerns are being counter-balanced by some rising wage inflation, with average hourly earnings (AHE) rising 2.9% year-over-year as of August; up from an average of 2.5% last year, according to data released with the above referenced labor report. But relative to history, wage growth does not suggest over-heating, suggesting the Federal Reserve has no intention to crimp economic growth. The fed funds rate will likely go up another 25 basis points at the September 26 meeting, with futures contracts at close to a 100% probability. A December hike looks likely as well, but the likelihood could ebb and flow depending on incoming economic data between now and then. We are only now getting to a positive real rate on the short end of the curve, so it’s appropriate to continue to cheer still-fairly loose financial conditions; but with the tightness in the labor market and the Fed also shrinking its balance sheet, inflation could pick up further from here, causing some volatility to return to markets.

So what?

Investor skepticism should, in our view, help to keep the U.S. bull market going, but risks in the near term have risen and gains should be more modest and pullbacks are likely. Some international markets have struggled to this point in the year, but we see signs that the divergence may be waning. We recommend a neutral overall equity stance and keeping a watchful eye on trade developments and confidence measures to help determine whether we see a breakthrough, or a breakdown.

Important Disclosure

Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

Ned Davis Research (NDR) Sentiment Poll shows perspective on a composite sentiment indicator designed to highlight short- to intermediate-term swings in investor psychology.

The Institute for Supply Management (ISM) Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.

The Institute for Supply Management Non-manufacturing Index is an index based on surveys of more than 400 non-manufacturing firms' purchasing and supply executives, within 60 sectors across the nation, by the Institute of Supply Management (ISM). The ISM Non-Manufacturing Index tracks economic data, like the ISM Non-Manufacturing Business Activity Index.

The S&P 500 Composite Index is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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